Tuesday, April 15, 2008

The Distressed Securities Strategy

This strategy involves investing in the securities of a company that is or is expected to be in trouble. Some distressed securities can trade at large discounts to their actual risk adjusted basis. This is due to the psychological effect that occurs in the marketplace when a firm gets into trouble or files for bankruptcy.

The marketplace can be ruthless when it comes to punishing the prices of troubled firms, oftentimes going too far, and in the process this creates undervalued securities. Part of this is due to the fact that demand for these securities is hurt because institutional investment managers, such as insurance companies, pensions, foundations, endowments, banks, trustees, are prohibited from investing in securities that classify as distressed. This is due to the strict rules that many money managers must follow due to regulations such as the ERISA (Employee Retirement Income Security Act, which governs employee benefit trusts), as well as the “Prudent Man Rule”.

Although some trusts are set up to allow managers to put money in alternative investments such as distressed securities, in general most of the large institutions have a low tolerance for risk and volatility and shy away from distressed securities. Therefore, hedge funds have ample space to exploit inefficiencies that can occur when distressed securities become undervalued. They are the vultures who clean up the mess after the party (bubble), usually at great profit….

A firm’s securities can become distressed for several reasons: poor management leading to poor performance, too much leverage, accounting fraud, or competitive pressures. When a firm becomes distressed, its securities will eventually trade with the lowest credit rating.

I say eventually because despite the fact that rating agencies are supposed to assign credit ratings based on a company’s prospects of default, they have been a bit behind the curve when it comes to recognizing when a firm is in trouble. This has become especially evident most recently during the subprime crisis, as rating agencies came out with downgrades long after it was obvious that many of the firms that they had been giving top quality ratings to were in the process of going down in flames. It is important to keep in mind that when a firm actually files for chapter 7 or chapter 11 bankruptcy its stock usually loses all its value….

In my view, investing in distressed securities is a strategy that anyone who manages money should learn as much as they can about. As I am writing this the US and global economy is in the midst of what has become known as the “subprime crisis.” Financial Bubbles are the norm given the economic, social, and governmental frameworks that we live in. As long as humans are on this planet there will always be opportunities to make money in distressed securities, as the opportunity is inherent in the system.

Is there a risk that with so much liquidity floating around in global financial markets that the garbage will get chased by too much money and cease to have value? If recent bubbles are any indication, I doubt it. More liquidity means more market extremes, both on the upside and on the downside, and more liquidity means more malinvestments (bad investment projects that eventually lead to losses) which create distressed securities.

Smart people will move in to save certain companies if there is money to be made, while the garbage will be left to rot and decompose in the bankruptcy courts. But the opportunities will only increase as the economy becomes more globalized and the pace of change continues to increase. This has greatly sped up the process known as “creative distruction.”

In general, timing and patience are key skills with this strategy, however, short term traders can also reap rewards by exploiting the long term trends as entire industries rise and fall. The most recent example would be the housing bubble and its effect on homebuilders and mortgage companies. You don’t have to be a genius to exploit the long term trends, you just recognize what is happening and utilize it in a disciplined way, as explained in the first section of this book. Learn to utilize financial bubbles and the opportunities they create because there will only be more of them in the future.

There are three ways of investing/trading in distressed securities.

A. Simply short the stock of the distressed firm and hold the position as the firm’s position continues to worsen over time. The risk here is that the firm will get its act together and the stock price will recover. As in all situations, careful analysis of the situation is therefore warranted. However, when large financial bubbles burst and entire sectors of the economy collapse, as many mortgage firms are currently, it is not difficult to find a strong long term downward trend to trade with. If a firm is showing signs of trouble, how quickly it is forced into bankruptcy depends on the interaction between its cost of debt (interest cost), available cash flow and reserves, and the general trend of its industry.

B. Use capital structure arbitrage to exploit the relative value between a firms stock and its debt. Depending on what a firms capital structure looks like, it may have several levels of capital outstanding. Capital structure is the mix of equity and debt that a company uses to finance its business. How volatile a firms earnings are over time has a big effect on its capital structure.

Firms in industries that are especially sensitive to the business cycle, are research intensive, or highly exposed to product liability lawsuits usually will minimize the amount of debt in their capital structure. Conversely, firms in the utility and airline industries routinely use debt heavily and will have a capital structure with a much higher debt ratio. How vulnerable a company, and as a result its securities, is to financial distress depends the amount of debt in the company (debt ratio), its cost (interest rate), and its cash flow.

C. Go long securities that are deeply undervalued because of their distressed state. A distressed securities hedge fund manager will look closely at a firm’s reorganization or bankruptcy and go long its undervalued securities. Which securities it buys depends on the situation, the extent to which the bankruptcy process is underway, and what presents the most value and potential for gain for the hedge fund If the firm can cut a deal with its creditors and recover successfully, its securities will rise in value and the hedge fund will profit.

If a hedge fund manager is able to buy undervalued securities when a firm is in bankruptcy, the return to the trade depends on the entry price during bankruptcy and the eventual exit price after the firm (hopefully) recovers from bankruptcy. Something to keep in mind when analyzing opportunity in distressed companies is if the company has tangible, physical assets of value that someone would be willing to buy. What’s more likely to recover and emerge from being distressed: an airline company that owns a fleet of jets that was forced into bankruptcy through mismanagement or a tech company with rented office space and outdated intellectual capital that has no market price?....

I certainly do not recommend that the individual investor attempt to pick a top or bottom with event driven approaches. Attempting to figure out what is going to happen to securities in a bankruptcy proceeding is not worth the time or risk involved. Simply ride the price down when it is clear a firm is headed for major problems, and get out before the bottom is actually hit. And don’t attempt to go long anything in the middle of a bankruptcy or reorganization when anything can happen, the risk/reward is unfavorable for the individual trader at that point. Let the heroes pick the tops and bottoms. Stay disciplined and do not ask a price trend to give you more than it is willing to.

A good strategy to follow is a simple combination of the above strategies. Go long the securities of firms that are in the initial stages of recovery, and short firms that are in a distressed state. It can be difficult to get a diversified portfolio when following this strategy, as there are only so many firms that are in a distressed or recovery mode. --John Bardacino